This chapter will introduce you to the fundamental theories and rules that guide the system of accounting. The key tenets of accounting are explained, including: double entry, substance over form, the matching principle, the revenue recognition principle, cost-benefit, materiality, and conservatism, as is their impact on the overall application of GAAP (Generally Accepted Accounting Principles). The underlying intent behind creating financial reports is for the information in the reports to be reliable enough to support sound business decision-making. By the time you finish this chapter, you should have a better understanding of the overall structure of accounting rules and guiding principles.
Modifying conventions (or constraints)
In certain instances, companies do not strictly apply accounting principles because of modifying
conventions (or constraints). Modifying conventions are customs emerging from accounting
practice that alter the results obtained from a strict application of accounting principles. Three
modifying conventions are cost-benefit, materiality, and conservatism.
Cost-benefit The cost-benefit consideration involves deciding whether the benefits of including
optional information in financial statements exceed the costs of providing the information. Users tend
to think information is cost free since they incur none of the costs of providing the information.
Preparers realize that providing information is costly. The benefits of using information should exceed
the costs of providing it. The measurement of benefits is inexact, which makes application of this
modifying convention difficult in practice.
Materiality Materiality is a modifying convention that allows accountants to deal with immaterial
(unimportant) items in an expedient but theoretically incorrect manner. The fundamental question
accountants must ask in judging the materiality of an item is whether a knowledgeable user's decisions
would be different if the information were presented in the theoretically correct manner. If not, the
item is immaterial and may be reported in a theoretically incorrect but expedient manner. For
instance, because inexpensive items such as calculators often do not make a difference in a statement
user's decision to invest in the company, they are immaterial (unimportant) and may be expensed
when purchased. However, because expensive items such as mainframe computers usually do make a
difference in such a decision, they are material (important) and should be recorded as assets and
depreciated. Accountants should record all material items in a theoretically correct manner. They may
record immaterial items in a theoretically incorrect manner simply because it is more convenient and
less expensive to do so. For example, they may debit the cost of a wastebasket to an expense account
rather than an asset account even though the wastebasket has an expected useful life of 30 years. It
simply is not worth the cost of recording depreciation expense on such a small item over its life.
The FASB defines materiality as "the magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances, makes it probable that the judgment of a
reasonable person relying on the information would have been changed or influenced by the omission
or misstatement". The term magnitude in this definition suggests that the materiality of an item may
be assessed by looking at its relative size. A USD 10,000 error in an expense in a company with
earnings of USD 30,000 is material. The same error in a company earning USD 30,000,000 may not
Materiality involves more than the relative dollar amounts. Often the nature of the item makes it
material. For example, it may be quite significant to know that a company is paying bribes or making
illegal political contributions, even if the dollar amounts of such items are relatively small.
Conservatism Conservatism means being cautious or prudent and making sure that assets and
net income are not overstated. Such overstatements can mislead potential investors in the company
and creditors making loans to the company. We apply conservatism when the lower-of-cost-or-market
rule is used for inventory (see Chapter 7). Accountants must realize a fine line exists between
conservative and incorrect accounting.
See Exhibit 30 for a summary of the modifying conventions and their importance. The next section of this chapter discusses the conceptual framework project of the Financial Accounting Standards Board. The FASB designed the conceptual framework project to resolve some disagreements about the proper theoretical foundation for accounting. We present only the portions of the project relevant to this text.
||Requires transfers of resources to be
recorded at prices
to the exchange at the time of exchange.
||Tells the accountant to record a transfer of resources at an objectively determinable amount at the time of exchange. Also, self-constructed assets are recorded at their actual cost rather than at some estimate of what they would have cost if they had been purchased.|
||Revenues should be earned and realized
before they are recognized (recorded).
||Informs accountant that revenues generally should be recognized when services are performed or goods are sold. Exceptions are made for items such as installment sales and long-term construction projects.|
||Expenses should be recognized (recorded) as they are incurred to produce revenues.||Indicates that expenses are to be recorded as soon as they are incurred rather than waiting until some future time.|
|Gain and loss
||Gains may be recorded only when realized,
but losses should be recorded when they
first become evident.
||Tells the accountant to be conservative when recognizing gains and losses. Gains can only be recognized when they have been realized through sale or exchange. Losses should be recognized as soon as they become evident. Thus, potential losses can be recorded, but only gains that have actually been realized can be recorded.|
||Information important enough to influence the decisions of an informed user of the financial statements should be disclosed. disclose.||Requires the accountant to disclose everything that is important. A good rule to follow is - if in doubt, disclosed. disclose. Another good rule is - if you are not consistent, disclose all the facts and the effect on income.|
|Cost-benefit||Optional information should be included financial statements only if the benefits providing it exceed its costs.||Lets the accountant know that information that is not required should be made available only if its benefits exceed its costs. An example may be companies going to the expense of providing information on the effects of inflation when the inflation rate is low and/or users do not seem to benefit significantly from the information.|
|Materiality||Only items that would affect a knowledgeable user's decision are material (important) and must be reported in a theoretically correct way.||Allow accountants to treat immaterial (relatively small dollar amount) information in a theoretically incorrect but expedient manner. For instance, a wastebasket can be expensed rather than capitalized and depreciated even though it may last for 30 years.|
|Conservatism||Transactions should be recorded so that assets and net income are not overstated.||Warns accountants that assets and net income are not to be overstated. "Anticipate (and record) all possible losses and do not anticipate (or record) any possible gains" is common advice under this constraint. Also, conservative application of the matching principle involves making sure that adjustments for expenses for such items as uncollectible accounts, warranties, and depreciation are adequate.|
Exhibit 30: Modifying conventions